The crypto community has continued to demonstrate a devotion to the ethos of decentralization — the transition from hierarchical structures of governance to “flat” playing fields, where all contributors have an opportunity to start from equal ground. Time and time again, history has shown that the concentration of power in centralized structures leads to corruption and results in the pollution of meaningful innovation.

Thankfully, the crypto community, with its globalized market and revolutionary technological foundations, may allow us to flip the script on historical patterns and create a new vision for the future of compensation and ownership.

Though sweat equity is not an entirely novel concept, blockchain technology fundamental to this new era of decentralization allows sweat equity distribution systems to be managed and implemented in much more intuitive ways.

“What if blockchains and smart contracts could be used to tokenize the work that goes into creating startups? Would this result in improved outcomes? Equitable distribution of wealth? More successful startups? More meaningful contributions?” — Marshall Lipman, Co-Founder of Sporos DAO.

This new era of sweat equity distribution establishes incentive alignment through the use of cryptographic tokens and blockchain validation. Smart contract transparency and immutability allows for the creation of incredibly effective tools for ensuring fair play. Web3 technologies have been designed to facilitate and encourage the level of personal trust and alignment required by startups, and for DAOs; this trust — established and validated by blockchain immutability — can allow for truly decentralized contributor compensation.

In this beginners guide to Sweat Equity Distribution, we will explain what sweat equity is, its history and origins from the Latin “Aequitas” and implementation in common law, its contemporary functions in finance, and why exactly DAO founders and contributors both now and in the future should be paying attention.

“Equity is the correction of the law where it is defective on account of its generality.” -Aristotle

In order to better understand the concept of equity in modernity, we must first understand its origins. Historically, equity comes from the Latin root “aequus,” meaning “even,” “fair”, or “equal.”

In Medieval England — the first recorded use of equity in a legal context — the Chancery originated as a distinct court of equity. Civilians who were unable to obtain an adequate common law remedy could petition the King of England, who would then refer the case to the Court of Chancery, where they could be provided more adaptable remedies based on notions of moral fairness - in contrast to the increasingly rigid courts of common law.

Many of the root tenets of English equity still exist to some extent today in American common law, and the term “equity” has taken on numerous derivative meanings, such as that of financial equity.

In modern finance, equity refers to the ownership of assets that may be accompanied by rights, duties, debts or other liabilities. For accounting purposes, equity is determined by subtracting liabilities from the value of assets. It’s important to note that “equity” and “sweat equity” are distinct.

Sweat equity, which was first used in the United States in 1937 by the American Friends Service Committee’s self-help housing project, takes the principles of fairness and equality set forth by Aristotle and applies them to the world of financial compensation. Additionally, novel technology like smart contract protocols allow for the equitable distribution of not just financial upside, but also governance rights within a company.

Michael Best summarizes sweat equity, well, best (pun intended), stating:

“Sweat Equity” is equity that startups and emerging companies issue to employees and others to attract and incent them, and is almost always “earned” over time (the “Sweat” in Sweat Equity). It has been a defining feature of the high impact entrepreneurship and venture capital universe for more than 50 years. In their efforts to change the world (and create a lot of wealth) entrepreneurs and venture investors alike, working together, have made hundreds of thousands of millionaires out of software programmers, bench scientists, lower and middle-level managers, and even receptionists. And the great thing is, pretty much everyone is happy about it — except maybe some of the folks who turned down sweat equity-laden job offers from risky startup businesses for the too-often nebulous job security promises of larger, more established employers.”

In essence, as will be defined for the purpose of this guide, sweat equity is a form of capital acquired through meaningful contribution.

The earliest stages of any DAO startup are characterized by ample amounts of time and effort invested by a founding team who believe they have spotted a problem in the market, and that they are capable of developing a plausible solution to that problem. Building these novel solutions is an inherently creative process. There are no instructions, pamphlets, or guidelines to follow, and even if there were; all the advice in the world cannot totally prepare you for what may or may not be required of you — especially considering the volatile nature of Web3 today. It can be hard, risky, and uncertain. Founders must demonstrate evidence of traction before they can begin effective fundraising efforts on behalf of the project. This phase of a startup’s life, often called bootstrapping, is when founders must sustain their efforts without external financing.

For startups both within Web3 and outside it, sweat equity distribution can be an effective method for contributors to acquire equity ownership in projects that are important to them, or that they otherwise financially believe in and support — regardless of pre-existing cash flow inhibitions.

This arrangement is — more often than not — defined in a legal contract, the terms of which are negotiated before work commences to give the contributor a reasonable expectation of what their ownership stake might look like, and whether or not that ownership will be represented as direct equity shares, options, warrants, or other equitable vehicles.

Unfortunately, the disparity between how an ideal sweat equity distribution system should operate and how it actually does operate is often quite different. Without distinctions between capital contributions and labor contributions, a contributor’s proportional equity can be diluted once the business begins to take on funding. If the distribution isn’t properly designed to ensure truly equitable allocations amongst contributors, team members may be compensated unfairly.

For DAOs, the distinction between capital contributions and labor contributions can be mitigated by restricting the liquidity or transferability of a token until the occurrence of certain consensus approved events, such as mergers and acquisitions or Initial Coin Offerings (ICOs).

If all contributors belong to the same class, they consequently share ownership equitably. It’s worth noting that many traditional companies frequently issue multiple classes of stock or equity, with each class having its own liquidation priority and voting rights. This complicates both stock value and accounting analysis, and the inherent centralization of these hierarchical structures do not reflect the ethos of decentralization.

Blockchain technology and the Smart Contract Protocols contained therein allow for the implementation of truly level playing fields, where all contributors can start from zero — including the owners (if designed properly). This can be accomplished in a number of ways, for instance via an irrevocable delegation of the initial governance rights and equity of founders to the smart contract itself — which may then redistribute all future rights to token holders in a manner established by a sweat equity distribution system.

Essentially, tokenization of equity and governance allows for the creation of a flat governance structure, where the only determinant factor to a contributor’s equity is the value they provide. So long as everyone starts from the same point, both the quality and quantity of contributions can be reflected in compensation fairly and accurately.

Classical equity management systems:

• Founder(s) promise a given % of their company in exchange for work

• Contributor works on the project in exchange for equity

• Terms are negotiated ahead of time and codified in a contract

• Sweat equity can be diluted by capital contributions

• Terms can change drastically without contributor input

• Disparities can arise between work promised and work delivered

• Flexing projects to different experts / skill sets is difficult at best

Smart Contract based equity management systems:

• Founders and contributors start on an equal playing field, equity proportional to contributions thereafter

• Contributor works on the project in exchange for equity

• Contribution is optional, contributors are free to determine how much time and effort to devote to a project as they see fit.

• Restricting liquidity can prevent dilution of sweat equity

• Capable of achieving a true “start from zero” playing field

• Contributions are directly correlative with compensation — blockchain validation and consensus approval remove disparities of work promised and work delivered

• Flexing projects or allocating tokens is a simple matter of consensus (Well, simple after the cat-herding required to get everyone to vote. That’s a topic for another time).

Leveraging blockchain technology to implement sweat equity solutions makes it easier for DAOs to attract and retain talent by providing a level playing field in which everyone shares in the project’s upside based on the value they contribute. A DAO can issue tokens to its contributors in exchange for their services and expertise. This is an appealing arrangement for many startup contributors. They get to work on an interesting project and earn a stake in its success. For many, it is fulfilling in a way that standard employment simply isn’t. It’s an appealing arrangement for the founder too, who gets to work with people who genuinely believe in their project without having to worry about cash flow. This aligns incentives all round.

Sweat equity management platforms such as Sporos DAO enable contributors to earn upside in multiple projects simultaneously when contributing to projects that reward in sweat equity tokens by eliminating non-competes from their legal agreements, and in fact encourage contributors to contribute their time to as many projects as they see fit.

By participating in a sweat equity distribution system, a contributor’s ownership stake in a project is proportional to the relative value of their contributions relative to those of other token holders. In addition, to maintain your level of ownership and governance, you must consistently provide value or risk having it diluted — this incentivizes participation.

As a contributor to an on-chain sweat equity distribution system, you immediately own sweat equity tokens in full. As a project manager, this helps to ensure that contributors truly care about the project they’re working on.

Furthermore, as an additional protection, equity owners have a residual claim on the firm’s eventual equity in the case of liquidation, whether by owner decision (such as consensus reached by token holders) or through a bankruptcy proceeding. If the equity is negative (a deficit), the unpaid creditors will incur a loss and the owners’ claim will be null and void. Under limited liability, owners are not obligated to pay the company’s obligations (so long as the company’s accounts are in order and the owners have not been implicated in fraud).

The advantages of sweat equity distribution for DAOs are clear. Many contributors are willing to be compensated with upside, but doing so while complying with U.S. legal, tax and securities regulations is costly and complicated.

Sweat equity distribution systems, such as those designed by Sporos DAO and Kali DAO, provide a simple, out-of-the-box solution designed to comply in the U.S and minimize compliance headaches for both the company and its contributors.

The system designed by the two teams starts with a strong foundation: the Kali DAO smart contract protocol. This protocol is designed to allow for intuitive proposal creation and dynamically amendable quorum definitions, allowing companies to adjust when and how voting occurs within their DAOs to best suit their needs. From there, the Sporos Equity LLC operating agreement mirrors and reflects the language of the smart contract to bring it into legal existence.

The resulting system is the Sporos Sweat Equity Management Platform. Enacting sweat equity from there is simple: contributors perform tasks and keep track of their hours. Hours can be tracked using a number of apps or tools — the choice of which is up to the DAO. After a given period of time (whatever the DAO as a whole identifies to be the proper “pay period”), the contributor will create a proposal listing out what objectives they’ve completed, and how long it took them to do so. In this proposal, the contributor will ask for compensation in the form of Sweat Equity Tokens — or SETs — in an amount consistent with their fair market rate within the DAO. After that, democracy runs its course! The proposal will either pass — and the tokens will be allocated to the contributor — or fail (at which point a discussion would likely need to be had. This is rare). Once a proposal has passed, the process repeats itself. Contributors can work as much or as little as they desire, and their efforts will be reflected in the amount of equity ownership they accrue in the company. This information is all accessible via Kali DAOs app — from each DAO member’s current allocation of equity to all past and pending proposals.

As this is occurring, the overhead and legal considerations of the DAO are mitigated on multiple fronts. First, the distribution of tokens are protected from securities registration considerations by remaining non-transferable, or illiquid. These tokens represent two things: governance rights, and warrant rights. The governance rights entitle contributors to participate in the control and direction of the company they care for. The warrant rights represent the contributor’s share of the company’s equity, or ownership. This equity is accessible only after a “graduation”, or liquidity event. By delaying the receipt of this equity, the DAO is allowed to build and develop while delaying the administrative burdens of managing cap tables and taxable events, and the contributor gets the upside of discounted equity in the company’s future value. In addition, this delay mitigates taxation considerations until the exercise of the warrants as well.

While this isn’t the only way for a sweat equity management system to function, it’s proven to be effective thus far.

As DAOs and the Web3 community at large continue to grow in popularity, the appeal of equitable compensation can be leveraged to attract top tier talent to quality projects. Sweat equity allows for relief from cash flow considerations in early stage startups, and provides a safe harbor in which these companies can grow into maturity.

There is certainly still work to be done regarding the application and administration of these revolutionary “true equity” systems, but, as with all things of value, the effort stands a strong chance to be worth the result — and if that isn’t reflective of equity, I’m not sure what is.

Sources:

https://lawexplores.com/equity-its-meaning-history-and-maxims/

https://www.worldwidejournals.com/paripex/recent_issues_pdf/2016/November/equity-and-law_November_2016_1905506201_4909311.pdf

https://www.newyorker.com/culture/infinite-scroll/the-promise-of-daos-the-latest-craze-in-crypto

https://www.michaelbest.com/portalresource/Introduction_to_Sweat_Equity

https://www.fortunebuilders.com/sweat-equity/

https://www.law.cornell.edu/wex/chancery

https://www.marketplace.org/2021/03/11/why-equity-can-mean-cash-in-real-estate-and-fairness-in-everyday-language/

The crypto community has continued to demonstrate a devotion to the ethos of decentralization — the transition from hierarchical structures of governance to “flat” playing fields, where all contributors have an opportunity to start from equal ground. Time and time again, history has shown that the concentration of power in centralized structures leads to corruption and results in the pollution of meaningful innovation.

Thankfully, the crypto community, with its globalized market and revolutionary technological foundations, may allow us to flip the script on historical patterns and create a new vision for the future of compensation and ownership.

Though sweat equity is not an entirely novel concept, blockchain technology fundamental to this new era of decentralization allows sweat equity distribution systems to be managed and implemented in much more intuitive ways.

“What if blockchains and smart contracts could be used to tokenize the work that goes into creating startups? Would this result in improved outcomes? Equitable distribution of wealth? More successful startups? More meaningful contributions?” — Marshall Lipman, Co-Founder of Sporos DAO.

This new era of sweat equity distribution establishes incentive alignment through the use of cryptographic tokens and blockchain validation. Smart contract transparency and immutability allows for the creation of incredibly effective tools for ensuring fair play. Web3 technologies have been designed to facilitate and encourage the level of personal trust and alignment required by startups, and for DAOs; this trust — established and validated by blockchain immutability — can allow for truly decentralized contributor compensation.

In this beginners guide to Sweat Equity Distribution, we will explain what sweat equity is, its history and origins from the Latin “Aequitas” and implementation in common law, its contemporary functions in finance, and why exactly DAO founders and contributors both now and in the future should be paying attention.

“Equity is the correction of the law where it is defective on account of its generality.” -Aristotle

In order to better understand the concept of equity in modernity, we must first understand its origins. Historically, equity comes from the Latin root “aequus,” meaning “even,” “fair”, or “equal.”

In Medieval England — the first recorded use of equity in a legal context — the Chancery originated as a distinct court of equity. Civilians who were unable to obtain an adequate common law remedy could petition the King of England, who would then refer the case to the Court of Chancery, where they could be provided more adaptable remedies based on notions of moral fairness - in contrast to the increasingly rigid courts of common law.

Many of the root tenets of English equity still exist to some extent today in American common law, and the term “equity” has taken on numerous derivative meanings, such as that of financial equity.

In modern finance, equity refers to the ownership of assets that may be accompanied by rights, duties, debts or other liabilities. For accounting purposes, equity is determined by subtracting liabilities from the value of assets. It’s important to note that “equity” and “sweat equity” are distinct.

Sweat equity, which was first used in the United States in 1937 by the American Friends Service Committee’s self-help housing project, takes the principles of fairness and equality set forth by Aristotle and applies them to the world of financial compensation. Additionally, novel technology like smart contract protocols allow for the equitable distribution of not just financial upside, but also governance rights within a company.

Michael Best summarizes sweat equity, well, best (pun intended), stating:

“Sweat Equity” is equity that startups and emerging companies issue to employees and others to attract and incent them, and is almost always “earned” over time (the “Sweat” in Sweat Equity). It has been a defining feature of the high impact entrepreneurship and venture capital universe for more than 50 years. In their efforts to change the world (and create a lot of wealth) entrepreneurs and venture investors alike, working together, have made hundreds of thousands of millionaires out of software programmers, bench scientists, lower and middle-level managers, and even receptionists. And the great thing is, pretty much everyone is happy about it — except maybe some of the folks who turned down sweat equity-laden job offers from risky startup businesses for the too-often nebulous job security promises of larger, more established employers.”

In essence, as will be defined for the purpose of this guide, sweat equity is a form of capital acquired through meaningful contribution.

The earliest stages of any DAO startup are characterized by ample amounts of time and effort invested by a founding team who believe they have spotted a problem in the market, and that they are capable of developing a plausible solution to that problem. Building these novel solutions is an inherently creative process. There are no instructions, pamphlets, or guidelines to follow, and even if there were; all the advice in the world cannot totally prepare you for what may or may not be required of you — especially considering the volatile nature of Web3 today. It can be hard, risky, and uncertain. Founders must demonstrate evidence of traction before they can begin effective fundraising efforts on behalf of the project. This phase of a startup’s life, often called bootstrapping, is when founders must sustain their efforts without external financing.

For startups both within Web3 and outside it, sweat equity distribution can be an effective method for contributors to acquire equity ownership in projects that are important to them, or that they otherwise financially believe in and support — regardless of pre-existing cash flow inhibitions.

This arrangement is — more often than not — defined in a legal contract, the terms of which are negotiated before work commences to give the contributor a reasonable expectation of what their ownership stake might look like, and whether or not that ownership will be represented as direct equity shares, options, warrants, or other equitable vehicles.

Unfortunately, the disparity between how an ideal sweat equity distribution system should operate and how it actually does operate is often quite different. Without distinctions between capital contributions and labor contributions, a contributor’s proportional equity can be diluted once the business begins to take on funding. If the distribution isn’t properly designed to ensure truly equitable allocations amongst contributors, team members may be compensated unfairly.

For DAOs, the distinction between capital contributions and labor contributions can be mitigated by restricting the liquidity or transferability of a token until the occurrence of certain consensus approved events, such as mergers and acquisitions or Initial Coin Offerings (ICOs).

If all contributors belong to the same class, they consequently share ownership equitably. It’s worth noting that many traditional companies frequently issue multiple classes of stock or equity, with each class having its own liquidation priority and voting rights. This complicates both stock value and accounting analysis, and the inherent centralization of these hierarchical structures do not reflect the ethos of decentralization.

Blockchain technology and the Smart Contract Protocols contained therein allow for the implementation of truly level playing fields, where all contributors can start from zero — including the owners (if designed properly). This can be accomplished in a number of ways, for instance via an irrevocable delegation of the initial governance rights and equity of founders to the smart contract itself — which may then redistribute all future rights to token holders in a manner established by a sweat equity distribution system.

Essentially, tokenization of equity and governance allows for the creation of a flat governance structure, where the only determinant factor to a contributor’s equity is the value they provide. So long as everyone starts from the same point, both the quality and quantity of contributions can be reflected in compensation fairly and accurately.

Classical equity management systems:

• Founder(s) promise a given % of their company in exchange for work

• Contributor works on the project in exchange for equity

• Terms are negotiated ahead of time and codified in a contract

• Sweat equity can be diluted by capital contributions

• Terms can change drastically without contributor input

• Disparities can arise between work promised and work delivered

• Flexing projects to different experts / skill sets is difficult at best

Smart Contract based equity management systems:

• Founders and contributors start on an equal playing field, equity proportional to contributions thereafter

• Contributor works on the project in exchange for equity

• Contribution is optional, contributors are free to determine how much time and effort to devote to a project as they see fit.

• Restricting liquidity can prevent dilution of sweat equity

• Capable of achieving a true “start from zero” playing field

• Contributions are directly correlative with compensation — blockchain validation and consensus approval remove disparities of work promised and work delivered

• Flexing projects or allocating tokens is a simple matter of consensus (Well, simple after the cat-herding required to get everyone to vote. That’s a topic for another time).

Leveraging blockchain technology to implement sweat equity solutions makes it easier for DAOs to attract and retain talent by providing a level playing field in which everyone shares in the project’s upside based on the value they contribute. A DAO can issue tokens to its contributors in exchange for their services and expertise. This is an appealing arrangement for many startup contributors. They get to work on an interesting project and earn a stake in its success. For many, it is fulfilling in a way that standard employment simply isn’t. It’s an appealing arrangement for the founder too, who gets to work with people who genuinely believe in their project without having to worry about cash flow. This aligns incentives all round.

Sweat equity management platforms such as Sporos DAO enable contributors to earn upside in multiple projects simultaneously when contributing to projects that reward in sweat equity tokens by eliminating non-competes from their legal agreements, and in fact encourage contributors to contribute their time to as many projects as they see fit.

By participating in a sweat equity distribution system, a contributor’s ownership stake in a project is proportional to the relative value of their contributions relative to those of other token holders. In addition, to maintain your level of ownership and governance, you must consistently provide value or risk having it diluted — this incentivizes participation.

As a contributor to an on-chain sweat equity distribution system, you immediately own sweat equity tokens in full. As a project manager, this helps to ensure that contributors truly care about the project they’re working on.

Furthermore, as an additional protection, equity owners have a residual claim on the firm’s eventual equity in the case of liquidation, whether by owner decision (such as consensus reached by token holders) or through a bankruptcy proceeding. If the equity is negative (a deficit), the unpaid creditors will incur a loss and the owners’ claim will be null and void. Under limited liability, owners are not obligated to pay the company’s obligations (so long as the company’s accounts are in order and the owners have not been implicated in fraud).

The advantages of sweat equity distribution for DAOs are clear. Many contributors are willing to be compensated with upside, but doing so while complying with U.S. legal, tax and securities regulations is costly and complicated.

Sweat equity distribution systems, such as those designed by Sporos DAO and Kali DAO, provide a simple, out-of-the-box solution designed to comply in the U.S and minimize compliance headaches for both the company and its contributors.

The system designed by the two teams starts with a strong foundation: the Kali DAO smart contract protocol. This protocol is designed to allow for intuitive proposal creation and dynamically amendable quorum definitions, allowing companies to adjust when and how voting occurs within their DAOs to best suit their needs. From there, the Sporos Equity LLC operating agreement mirrors and reflects the language of the smart contract to bring it into legal existence.

The resulting system is the Sporos Sweat Equity Management Platform. Enacting sweat equity from there is simple: contributors perform tasks and keep track of their hours. Hours can be tracked using a number of apps or tools — the choice of which is up to the DAO. After a given period of time (whatever the DAO as a whole identifies to be the proper “pay period”), the contributor will create a proposal listing out what objectives they’ve completed, and how long it took them to do so. In this proposal, the contributor will ask for compensation in the form of Sweat Equity Tokens — or SETs — in an amount consistent with their fair market rate within the DAO. After that, democracy runs its course! The proposal will either pass — and the tokens will be allocated to the contributor — or fail (at which point a discussion would likely need to be had. This is rare). Once a proposal has passed, the process repeats itself. Contributors can work as much or as little as they desire, and their efforts will be reflected in the amount of equity ownership they accrue in the company. This information is all accessible via Kali DAOs app — from each DAO member’s current allocation of equity to all past and pending proposals.

As this is occurring, the overhead and legal considerations of the DAO are mitigated on multiple fronts. First, the distribution of tokens are protected from securities registration considerations by remaining non-transferable, or illiquid. These tokens represent two things: governance rights, and warrant rights. The governance rights entitle contributors to participate in the control and direction of the company they care for. The warrant rights represent the contributor’s share of the company’s equity, or ownership. This equity is accessible only after a “graduation”, or liquidity event. By delaying the receipt of this equity, the DAO is allowed to build and develop while delaying the administrative burdens of managing cap tables and taxable events, and the contributor gets the upside of discounted equity in the company’s future value. In addition, this delay mitigates taxation considerations until the exercise of the warrants as well.

While this isn’t the only way for a sweat equity management system to function, it’s proven to be effective thus far.

As DAOs and the Web3 community at large continue to grow in popularity, the appeal of equitable compensation can be leveraged to attract top tier talent to quality projects. Sweat equity allows for relief from cash flow considerations in early stage startups, and provides a safe harbor in which these companies can grow into maturity.

There is certainly still work to be done regarding the application and administration of these revolutionary “true equity” systems, but, as with all things of value, the effort stands a strong chance to be worth the result — and if that isn’t reflective of equity, I’m not sure what is.

Sources:

https://lawexplores.com/equity-its-meaning-history-and-maxims/

https://www.worldwidejournals.com/paripex/recent_issues_pdf/2016/November/equity-and-law_November_2016_1905506201_4909311.pdf

https://www.newyorker.com/culture/infinite-scroll/the-promise-of-daos-the-latest-craze-in-crypto

https://www.michaelbest.com/portalresource/Introduction_to_Sweat_Equity

https://www.fortunebuilders.com/sweat-equity/

https://www.law.cornell.edu/wex/chancery

https://www.marketplace.org/2021/03/11/why-equity-can-mean-cash-in-real-estate-and-fairness-in-everyday-language/